Understanding Network Effects

I am a big fan of A16Z podcasts, and they just released terrific episode on Network Effects.

Network Effects is an important and somewhat confusing topic.

The reason Network Effects are important is that the businesses with true Network Effects are highly defensible, have strong retention and engagement, exhibit characteristics of monopoly, and tend to last for a long time.

Definition of Network Effects

A Network Effect is achieved when adding new users creates value for existing users.

That is, the overall experience and value being inside the network increases with the addition of new users.

How exactly does it work?

Users want something from each other. Each user in such a network is both producer and consumer.

For example, I write blog posts, and I also read them. I post tweets, and I read other people’s tweets. I check traffic on Waze and I also contribute to traffic reports on Waze.

In other words, I am both a producer and consumer. I am both a reader and a writer.

Businesses with Strong Network Effects

Let’s consider three different types of businesses with strong network effects – Social Networks, Multiplayer Games and Sensor Networks.

Let’s start with a canonical example – Facebook. It is famous for its Network Effects and organic growth. Facebook started at Harvard and grew deliberately and slowly to ensure strong connectivity. The more friends and family that joined, the more value existing users derived.

The core Network Effect is that basic activity on Facebook is sharing or posting to your network. Posts are the glue and the trigger.

Each Facebook user is both a producer and consumer, both the writer and the reader.

Next, let’s look at Twitter, which, much like Facebook, has strong Network Effects. The interesting thing about Twitter is that because it is based on a unidirectional “follow” relationship, it has stronger virality. News spreads a lot faster on Twitter. Yet, Facebook is a stronger network because of the family and friendship ties with personal photos acting as a super glue.

Another kind of business that has strong network effects are Multiplayer games.

By definition, these kinds of games are designed to be played with others. When new players join, existing players are better off. Just like how on Facebook we see formation of cliques of friends, in the Multiplayer games we see cliques of players.

The glue and the trigger for the Network Effects in games is the game itself and objects inside the game.

They provide touch points and the opportunities to co-create the game world for the players. The games are highly sticky because the players need to level up, and starting from scratch in these co-created worlds is very costly.

Lastly, consider Waze, a traffic app acquired by Google. Cleverly, Waze creators realized that people in traffic would be willing to share their location in exchange for being informed about the overall traffic patterns and alternative routes.

Each app writes data points and reads back the traffic. Each app is both a producer and consumer of information.

Network Effects and Virality

Next lets look at the difference between Network Effects and Virality, Marketplaces and Economies of Scale — terms often confused with Network Effects.

Virality is about something spreading quickly over an existing network. Network effects, on the other hand, are about creation of a brand new network.

For example, word of mouth is an example of virality – news about an attack in Paris travels quickly through Twitter. PokemonGo is another example of virality – millions of people raced to play the game. And of course, funny cat videos on YouTube are known to be viral.

Virality is great and is really important in successful businesses, but it doesn’t always last. All of the examples above are examples of short phenomenon that spike up and then go away. We don’t think of these events as sustainable over time. They are hits, or outliers, and not a solid foundation for the business.

Network Effects and Marketplaces

Next, let’s look at the relationship between Marketplaces and Network Effects.

It would seem that businesses like Uber and Airbnb would have built-in Network Effects, and they do to an extent for some subset of the users, but it doesn’t appear to be true at scale.

Marketplaces have two sides — supply and demand, producers and consumers.

In the case of Uber and Airbnb, some producers happen to be consumers, but not all. Not all Uber drivers take Uber rides, and not all Uber riders are the drivers. Not all Airbnb hosts are also guests and not all Airbnb guests are hosts.

These, and other Marketplaces, have strong virality via word of mouth, but weak network effects.

Economies of Scale vs. Network Effects

In addition, Marketplaces and other businesses at scale achieve supply efficiency or economies of scale.

For example, UberPool becomes cheaper at scale. That is, once enough people want it, your rides get cheaper, so in a way, there is a Network Effect by virtue of more users joining.

Another example would be delivery services like Postmates. If the volume of the orders is low, then each delivery is a one off and expensive. As the volume increases and gets clustered, then deliveries become cheaper because you can aggregate deliveries together along the same route.

In general, the economies of scale are achieved as the business grows. For example, the business can negotiate with suppliers and get a discount in exchange for buying in bulk.

This has nothing to do with the Network Effects – it is related to monopolies and business defensibility.

In general, the businesses with bigger margins at scale become more powerful and more defensible.

Network Effects in Nature

Before we dive into the mechanics of Network Effects, let’s turn to nature which is full of Network Effects.

In science, they are called self-organizing networks. If you aren’t familiar with this concept, I highly recommend you read Complexity, which is one of my favorite science books.

Carbon-based life, the entire living world around us, is based on DNA and RNA, which has the fundamental ability to copy itself. More importantly, DNA and RNA likely emerged as a result of a process called auto-catalysis.

This may sound like a bunch of scientific gibberish, but it is actually really easy to understand and plays a key role in understanding Network Effects.

Imagine the basic blocks of life called A and B. One day they got together and created a new block called AB. Next, A and B blocks can be mixed with AB to form AAB or ABB. Next, you can make AAAB, AABB, BAAB, BABB and so on.

That is, simple combinations of basic blocks can create more and more complex blocks and chains. A virtuous cycle or feedback loop.

How to Engineer the Network Effects

Now we are ready to understand how you may engineer or check for Network Effects in a business.

Each node needs to be part of a simple feedback loop.

On Facebook, the users are readers and writers. Reading and writing creates a strong feedback loop. It is this loop that pulls the users back to use the service. Much like with basic building blocks of life, it is not one to one interactions that are so precious, it is the one to many interactions.

The defensibility of Facebook is the network structure and the ongoing Network Effects – the support and formation of new parts of the network. Users who try to leave are constantly being pulled back by their friends and families.

If you found this post helpful, please give examples of other types of businesses with strong Network Effects. Let’s have a discussion and debate!